People walk on a bridge in a "smart low-carbon energy" district in Qingdao, China.
Adrian, a financial adviser to the International Monetary Fund, pointed out in a blog post a few days ago that there has been a sense of optimism in financial markets in recent months, as investors believe that the fight against inflation is heading for the "last mile" and that central banks will ease monetary policy in the coming months. However, Adrian pointed out that this "last mile" is likely to be bumpy and central banks need to remain vigilant.
Adrian noted that geopolitical tensions have the potential to exacerbate and affect investor sentiment. The pressure on the commercial real estate market has become more severe and may put more pressure on some lenders. China's financial markets continue to be weighed down by ongoing problems in the property sector. In addition to these more pressing issues, debt vulnerabilities continue to grow. Although interest rates remain high and economic growth is likely not to accelerate, the public and private sectors in many countries are still borrowing heavily.
He said there was recent evidence that the downward trend in inflation in some countries may have stalled, and that underlying inflation in some sectors may persist. In some cases, core inflation has been higher than analysts' forecasts for months. Higher-than-expected data could test the "last mile" narrative and the associated investor optimism, and could lead to repricing and increased volatility in financial markets.
Sticky inflation
Adrian said inflation has recently diverged across countries after a rapid global slowdown. So far, this year's data shows that core inflation has accelerated higher in the last three months in some major developed and emerging economies (Czech Republic, France, Germany, Italy, Philippines, South Africa, Sweden, the United Kingdom, and the United States) compared to the previous three months.
At the same time, rising geopolitical tensions could further disrupt shipping and energy production and push inflation higher again. So far, financial markets have generally remained optimistic about stalled inflation and other headwinds and risks, with volatility in major asset classes currently at low levels, despite high indicators of economic policy uncertainty.
Repricing risk
Adrian said volatility and uncertainty tend to diverge before asset price volatility soars. Investors reassess asset values to account for high levels of uncertainty after adverse shocks. In this case, asset price volatility rises significantly.
He noted that one of the adverse shocks on the "last mile" could be higher-than-expected inflation. Although, as noted above, future inflation expectations will rise in some countries, investors are expecting a sharp cut in policy rates this year – with the European Central Bank and the Central Bank of Brazil cutting rates by about 75 basis points. Despite a series of higher-than-expected U.S. inflation, the Fed is still expected to cut interest rates by about 50 basis points. Investors seem to believe that when inflation slows further, the data-driven central bank will ease monetary policy. But if inflation remains high, such high expectations could be dashed, leading to a related sell-off in bonds, equities, and even cryptoassets.
Persist in the fight against inflation
Adrian said the stalling trend of slowing inflation could come as a surprise to investors as they become increasingly convinced that the battle against inflation has been won and that we will return to the era of low interest rates. In economies where inflation is consistently above target, central banks should not loosen monetary policy too soon to avoid having to re-tighten it later. The central bank should also dampen investors' overly optimistic expectations of monetary policy easing, which has brought some kind of prosperity to financial markets. Of course, if progress in the fight against inflation shows that inflation is continuing to move closer to target, then the central bank should gradually reduce the degree of policy tightening.
He stressed that a multi-pronged approach is necessary to maintain financial stability on the "last mile". Financial regulators should take steps to ensure that banks and other institutions can withstand risks such as default, using stress tests, early corrective actions, and other supervisory tools. Central banks should ensure that banks have access to liquidity facilities when needed and are ready to intervene early to remove financial pressures in the financial sector.
